When is a Rose Not a Rose? IRS Tries to Plug Carried Interest Loophole by Claiming Roses are Not Flowers

The sweeping tax law passed in December requires partners holding some “carried interests” (partnership interests disproportionately large as compared to the relative capital contributed) to recognize gain at ordinary income tax rates (up to 37%) if their holding periods do not exceed three years, as opposed to the one-year holding period normally required to qualify for 20%-tax-rate long-term capital gain. The idea is that these interests are associated with services — often performed by hedge fund and private equity managers — that don’t carry the investment risk associated with a normal capital asset, and therefore holders of these partnership interests should have to own the interests longer to qualify for a low tax rate.

The statute categorically exempts partnership interests held by “corporations” from the new rules. Without explanation, the IRS announced this week it will take the position that “S corporations” are not “corporations” for the purposes of the carried interest law, even though by definition the opposite is true throughout the Internal Revenue Code. Their interpretation is akin to claiming roses aren’t flowers.

There are common sense reasons why S corporations should not be exempt from the carried interest statute. Because S corporations are pass-through entities, there is no practical difference between an individual owning a carried interest directly, as opposed to owning it through an S corporation. Yet read literally, the statute produces different results in these practically comparable situations.

Still, statutes are supposed to mean what they say. S corporations are corporations, just like roses are flowers. Unless Congress changes the statute, the Internal Revenue Service may have a hard time defending its position in litigation.

See our prior discussion of the new carried interest law:

E. John Wagner, II